Where is the bitcoin price headed next? That’s the question nervous bitcoin investors are asking after the price of the virtual currency soared to a high of $US1240 before plummeting back to $US870 in trading on the Tokyo-based Mt Gox exchange on Thursday, after China banned its banks from handling bitcoin transactions. By Friday, the virtual currency had clawed back some ground to trade at the $US1020 level – which still represents a 7500 per cent appreciation in its price this year.

Although Beijing did not ban the use of bitcoin altogether, it highlighted some of the dangers associated with its use, including money laundering and criminality. At the same time, officials in France and from the European Union voiced concerns about the potential for people to use the virtual currency for speculative trading and money laundering.

These latest warnings are in stark contrast to the cautious blessing US central bank boss
Ben Bernanke
gave to virtual currencies such as bitcoin.

In a letter to US senators last month, he noted: “They may hold ­long-term promise, particularly if the innovations promote a faster, more secure and more efficient payment system."

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And they come at a time when Wall Street is focusing more attention on bitcoins. This week, David Woo, a currency analyst at Bank of America Merrill Lynch, put out an 11-page bitcoin report that estimated its “maximum fair value" at $US1300. “We believe bitcoin could become a major means of payment for e-commerce and may emerge as a serious competitor to traditional money-transfer providers," it said.

Interest in the virtual currency has also been spurred by growing unease over the money-printing policies being pursued by the world’s major central banks. bitcoins are attractive because they are generated by a computer program at a predetermined rate – with 25 new ones created every 10 minutes.

There are 12 million bitcoins at present and there is an upper limit of 21 million bitcoins built into the software. Once created, bitcoins can be used for purchases or traded on unregulated internet currency exchanges such as the San Francisco-based Coinbase.com or Tokyo-based Mt Gox.

bitcoins’ increased popularity has prompted a growing number of venture capitalists and technology enthusiasts to pour money into new businesses that aim to capitalise on its potential as an alternative to traditional methods of payment. More merchants are accepting bitcoins as payment because they don’t have to pay hefty credit card transaction fees.

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Silk Road closure

The virtual currency climbed to $US266 in April after the Cyprus bank bailout inflicted large losses on depositors. In early October, its price plunged to around $US90 after one of the most active bitcoin markets, Silk Road, was shut down. US authorities claim Silk Road was an online marketplace for everything from heroin to forged passports.

Sentiment toward the virtual currency also soured after hackers attacked the supposedly secure bitcoin wallet, Inputs.io, and stole 4100 bitcoins in late October.

Given this volatility, should individual investors take a closer look at bitcoins?

Perpetual head of Investment Market Research
Matthew Sherwood
says the answer is “probably not".

“It’s an artificial currency, not backed by the productive capacity of any economy, it doesn’t produce any income, and it’s not regulated by any central bank or regulatory authority. So it’s hard to place any trust in it because it’s literally backed by nothing", he says. “Investors may use it in transactions, but I would certainly worry about holding it as a reserve asset. I think it is foolhardy to consider it an asset."

Sherwood points out that one of the attractions of bitcoin is that it allows buyers and sellers to transact directly, without having to go through major institutions, which often charge hefty fees.

“The fees and delays involved in transferring money across borders via bitcoin are quite minor relative to those imposed by banks and their intermediaries in the standard way," he says. “Purchasers can use it as a currency that they hold in their accounts and control themselves, and this helps them mitigate exchange-rate risk. So it’s good from a transaction point of view, if not from a portfolio point of view." He also notes bitcoin’s growing popularity, which has been boosted by its role in dubious online markets, has attracted speculators.

“bitcoins are sometimes traded as an investment by speculators who expect the currency to increase in value as its popularity widens, and there are some reports of prices being manipulated by speculators. So investors need to be cautious about going in blindly and finding themselves on the wrong side of the ledger," he says.

Here to stay?

So are bitcoins here to stay?

“We’ll know the answer to that when the market next runs into stress. bitcoin only exists because at the moment people trust it and consider it is no different to any other currency. But it’s hard to know how it would behave during periods of market turmoil," Sherwood says.

“bitcoin has been growing strongly, but that’s been during a period when conditions have been favourable. However, as we saw during the global financial crisis, the behaviour of assets can change dramatically when the operating environment changes. And bitcoin is no different."

Citibank currency analyst
Steven Englander
has identified a further risk – that bitcoin’s growing popularity could lead to the creation of copycat currencies that could undermine one of its greatest advantages as an investment – that only a finite number of bitcoins can ever exist.

Meanwhile,
Adam Posen
, head of the Peterson Institute for International Economics points out that “history is littered with [failed] alternative currencies".

Posen argues that, to succeed, bitcoin must become both a way for people to store their savings, as well as a much more widely accepted means of payment. However, he predicts that extreme price volatility will deter many investors from owning bitcoins. In addition, while people can be forced to accept, say, US dollars as payment, there is no compulsion on vendors to accept bitcoins.